Playing Opposites: Why and How Some Pros Go Short on Stocks

Learn how following short interest and other short-selling metrics can help investors gain valuable insights into companies and markets.

https://tickertapecdn.tdameritrade.com/assets/images/pages/md/One of these plastic owls is not like the others: Selling short
6 min read
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Key Takeaways

  • Short selling may have negative connotations, but it plays a role in liquidity and price discovery

  • The short interest ratio is one way to identify possible “short squeeze” targets
  • Consider monitoring short interest metrics, even if you’re an investor with no intention of short selling

Buy low; sell high—it’s the first rule of trading.

But some traders and fund managers flip the order by selling first and hoping to buy back later at a profit. They’re called short sellers, aka “shorts.” And a few of them made the headlines in 2021 as a few heavily shorted stocks rocketed higher in apparent short squeezes (more on that in a bit).

Short selling plays a role in price discovery and liquidity—two components of healthy and efficient markets. It’s also not for everyone, as there are numerous risks, and the mechanics are somewhat complex. But by understanding the basics of short selling and so-called “short interest,” investors can gain valuable insights into companies and markets.

What Is Short Selling?

A short position is essentially a trade that aims to profit from a decline in the price of a stock or asset. That may seem straightforward enough, but short selling stocks can quickly get complicated and risky. Before you consider initiating a short position, it’s important to understand the basics.

But even if you have no intention of becoming a short seller, getting a handle on what short sellers are doing and why, as well as what that activity might say about a company, industry, or broader market could give you some added perspective as an investor.

How Does Short Selling Work?

Investors who sell short borrow stock from a broker and then sell the shares. At some point, the investor must close the short position by buying back the same number of shares and returning those shares to the broker.

If the price drops, the investor can buy back the stock at the lower price and pocket the difference. For example, if a stock shorted at $50 is bought back at $40, the seller realizes a $10 per-share profit (minus transaction costs). On the other hand, a short seller holding a losing position may receive a margin call and be required to put up more money.

Granted, this is an oversimplified explanation of the process of short selling stocks, so before you jump in to such a trade, learn about the specifics, such as margin accounts, margin calls, “hard-to-borrow” shares, and other unique characteristics of short selling.

Who Are the Short Sellers?

Short selling tends to be associated with the realm of hedge fund traders and other experienced market professionals with large amounts of capital and the capacity to absorb losses when the market moves against them. Typically, professional traders might sell short if they are bearish on a certain stock or industry, or they may be angling for a management shake-up at a company or some other change. While that may be the popular image of short sellers, some short sellers are retail investors with a high risk tolerance.

Where Can I Find Information on Short Selling and Short Interest?

Data on short interest—the number of shares outstanding that have been sold short—is available for most U.S. companies listed on major exchanges. The New York Stock Exchange (NYSE) releases a short interest compilation every two weeks.

A glance at these reports often reveals familiar names. Examples might include:

  • A pharmaceutical company that’s awaiting regulatory approval for a new drug.
  • A retailer that is struggling to develop a viable long-term strategy.
  • A company whose share price has surged—in the view of short sellers—too far, too fast, such that it’s become detached from its underlying fundamentals.

For example, during a slump in commodity prices, you might find energy or mining companies ranked among the most-shorted companies.

There are often stories beyond the numbers. Do you see any stocks you’re considering as investments, or that are currently in your portfolio? Think about why other people may have opposing viewpoints. Check recent earnings reports or listen to conference calls for color and context that may have implications for shareholders. Short interest readings are also available when you log in to your account at tdameritrade.com.

How Can Short Selling Be Measured or Quantified?

Market professionals follow key metrics, including “shorts as a percentage of float,” which reflects the number of short-sold shares in proportion to the “float,” or the total number of shares available for trading in the public markets.

Most stocks have a small amount of short interest, usually in the single digits. The higher that percentage goes, the greater the bearish sentiment might be surrounding that stock. If the float reaches 10% or higher, some market pros consider it a red flag. See figure 1.

FIGURE 1: INTERESTING? To view short interest as a percentage of available float, log in to your account at tdameritrade.com, look under Research & Ideas > Stock Profile, and type in any symbol. At 20.47%, the short interest percentage in this example stock is quite high relative to the broader market. Plus, over the past 12 months, the stock has delivered negative earnings of $12.26 per share. Source: tdameritrade.com.

“Days to cover,” also referred to as the short interest ratio, indicates how long it would take to cover, or buy back, all the shorted shares. This is calculated by dividing the number of shares sold short by the average daily trading volume. Some view this ratio as a measure of the future buying pressure on a stock. Some short sellers look for about seven days or fewer to cover before shorting a stock.

What About the “Short Squeeze”?

A short squeeze can happen when bullish news pushes a stock price higher, prompting short sellers to head for the exits all at once. As the shorts scramble to buy back and cover losses, upward momentum builds upon itself and the stock can move sharply higher. The longer the days to cover, the more pronounced this effect can be.

Short interest can also be applied alongside chart indicators, such as moving averages, for signals on when it may be time to exit a stock. For example, a combination of high short interest and a drop below the 52-week low or the 200-day moving average might indicate “look out below.”

What Might Short Selling Activity Indicate?

Across the broader market, short interest has not been historically high in recent years. Near the end of 2018, for example, short interest in the S&P 500 was about 2.17% of shares outstanding, down from 2.3% in late 2017, according to FactSet Research Systems. Total NYSE short interest at the end of October 2018—a quite volatile month—was about 16 billion shares, down from 16.4 billion a year earlier.

During the heady days of the 2008-09 financial crisis, short interest topped 19 billion shares. A couple years later, as markets recovered and began their multi-year march higher, it fell below 12 billion shares.

The Short Answer on Short Selling

Again, short selling isn’t for everyone, as it is risky and complicated. Remember: A stock can only drop as far as zero, but theoretically, it could rise to infinity.

But that doesn’t mean short selling has no merit. It can be a check on management excess, a dose of reality when a company has gotten ahead of its fundamentals, and can help keep markets liquid and efficient. As an investor, even if you have no intention of short selling stocks, you might find value in understanding, and keeping an eye on, short selling metrics and dynamics.

For more, have a look at the video below.

Short Selling: Can You Profit from Falling Stocks?
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Key Takeaways

  • Short selling may have negative connotations, but it plays a role in liquidity and price discovery

  • The short interest ratio is one way to identify possible “short squeeze” targets
  • Consider monitoring short interest metrics, even if you’re an investor with no intention of short selling

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